What if Tax Rates Rise?

Overview

Current geo-political events and domestic policies are having an impact on the United States economy.  Farmers are facing incredibly higher input costs (particularly fuel and fertilizer) associated with planting spring 2022 crops.  Higher energy costs will ripple throughout the entire economy with the burden felt primarily by the middle to lower income groups. 

During practically all of 2021, talk in the Congress focused on increasing taxes.  But Senators Manchin and Sinema put a stop to that.  However, the enormous amount of government spending hasn’t stopped.  The Senate, on March 10 approved another massive $1.5 trillion omnibus spending bill.  The legislation will be signed into law.  That spending is on top of the massive amounts of spending that has occurred since the enactment of the CARES Act in late March of 2020.  The infusion of all of these dollars into the economy has caused the money supply to quadruple and is fueling inflation. 

As problems continue to rise around the world, the temptation, of course, will be for the Congress to increase taxes to generate even more revenue for itself to fund U.S. involvement in these affairs.  Will it be able to push through a tax increase before the fall Congressional elections?  If so, what might be some good tax moves to make if rates increase?

Tax strategies in anticipation of higher tax rates – it’s the topic of today’s post.

Tax Strategies

In a stable tax environment (which hasn’t been present for some time) when tax rates are not anticipated to change, the typical strategy is to delay income recognition and accelerate deductions.  But, when tax rates are expected to rise, the opposite strategy is true – accelerate income into the current (lower tax rate) year and postpone deductions to the next (higher tax rate) year. 

So how can this technique be accomplished?  Here are some possibilities:

Income acceleration.    Numerous techniques can be available based on the facts of each particular taxpayer.  One strategy is to currently sell appreciated assets.  This will trigger capital gain in the current year, rather than waiting until a later year when rates might be higher.  Also, instead of using a like-kind exchanges for real estate consider a taxable exchange.  If cancellation of debt income needs to be recognized, it might be better to time transactions such that the income is triggered in the current year.  For installment sales, such as the tax reporting for deferred grain contracts, elect out of installment treatment by reporting the income currently.  If an investment has been made in a qualified opportunity fund, consider selling or gifting it this year. 

For farming (and other) businesses, review depreciable asset to see if any assets need to be demolished or have become obsolete or otherwise abandoned, or are no longer in service.  Is there any depreciation recapture that could be triggered in the current year?  Depreciation recapture is taxed at (higher) ordinary income tax rates.  Also, if the business is presently structured as an S corporation, consider changing to a partnership.  For a farming business, not only may this result in an increase in payment limits under the farm programs, it could trigger gain recognition on the appreciation of assets in the S corporation and result in a higher income tax basis. 

Defer deductions.  As noted above, another general strategy to employ when tax rates are anticipated to be higher in the future is to defer claiming deductions.  Doing so maximizes the value of the deductions.  This can be accomplished, depending on the facts of each situation, by purchasing capital assets used in the trade or business in the higher tax rate year and otherwise making business-related investments when rates are higher.  Also, it might be better in some circumstances and with respect to certain business assets to depreciate them rather than claim either expense method depreciation or first-year bonus depreciation.  On that point, give consideration to what might be done with the assets.  Is near term depreciation recapture a possibility?  Also, an evaluation should be made of whether it might be better to structure a lease as an operating lease rather than a capital lease.  A common aspect of an operating lease is that it usually has fewer upfront expenses. 

Another way to move deductions into a future higher tax year is to pay employee accrued vacation time and bonuses after March 15.  As applied to farming and ranching operation this point is limited to those that have employees, but for those that do, the strategy will cause the deduction and the expense to match on the tax return.  In that same vein, wait to establish a qualified retirement plan until the future, higher tax rate, year.  That will generate a larger deduction.  In the current year, a non-qualified retirement plan could be created. 

If charitable deductions are a normal or desired part of the overall tax plan, bunch them up in a higher tax rate year.   This has been a strategy that some have employed in recent years as the result of tax law changes, but it also works when rates are anticipated to be higher in the future. 

Farm income averaging.  A major tool for farmers is the ability to elect to income average over a three-year period.  The technique works well when rates rise because it allows the farmer to reduce income in the high tax rate year and spread it back over prior lower rate years and fill up any unused bracket amount. Of course, the technical rules must be followed, and only “electable farm income” counts, but it is a helpful strategy that many farmers and utilize. 

Conclusion

Tax planning always takes a bit of foresight as to how economic conditions will impact a client and that client’s business.  If the Congress reacts to those economic conditions with a political response that results in higher taxes, that has a bearing on tax planning.  While it is not possible to predict the future, having a tax plan (as well as an estate/business plan) in place that is flexible enough to change with the rules can provide lasting benefits. 

Also, I am sure that you can think of tax strategies in addition to those I have listed above.